Valuation of a SaaS Business
When valuing a technology business, the first question is whether to look at a multiple of SDE, EBITDA or Revenue.
Stories of wildly high revenue multiples for unicorn SaaS businesses can seem at odds with the modest earnings multiples for smaller SaaS businesses, which serves to confuse the information in the marketplace. So, which one is right? The answer is both, but they are entirely different investment propositions.
The difference between the two situations comes down to the size and growth of the businesses in question.
SDE vs. EBITDA vs. Revenue
Most small businesses valued at under $5,000,000 are valued using a multiple of Seller Discretionary Earnings (SDE or sometimes also called seller discretionary cash flow) particularly if they are relatively slow growing and do not have a management team in place.
SDE is the profit left to the business owner once all costs of goods sold and critical (i.e. non-discretionary) operating expenses have been deducted from the gross income. Crucially, any owner salary/dividends can be added back to the profit number, too.
SDE = Revenue – CGS – OpExp + Owner Compensation
SDE is used for small business valuation to demonstrate the true underlying earnings power of the business. Most small businesses are owner-operated and somewhat owner-reliant and therefore have an associated owner salary and expenses. The owner is likely to pay themselves a salary for the work – which may not be correlated with the market rate and pay several personal items through the business for tax efficiency. These are acceptable addbacks to reflect the true earnings power of the business.
The situation changes though as businesses grow larger. In bigger companies, there are more employees and more management personnel. Similarly, the ownership structure tends to fragment with several shareholders who typically play a less active role in the business, often hiring a general manager or CEO to oversee operations. In this situation, any owner compensation or discretionary expenses should be added back into the business to show its true earnings power. A new benchmark of earnings before interest, taxes, depreciation and amortization (EBITDA) is employed. In acquisitions with companies with over $5,000,000 in value, EBITDA multiples are almost exclusively used throughout the industry.
For most businesses, the valuation benchmark debate stops there. Either SDE or EBITDA is considered the best proxy for the business’ future cash flows and is therefore the basis of its valuation. For SaaS companies, however, the EBITDA being generated today – which could be zero – is not always a good proxy for potential future earnings. This is because growing SaaS businesses make significant upfront (and sunk) investments in growth, which are all expensed in current EBITDA. Owing to their recurring revenue model and assuming customers stay with the business, the profit in the future will expand significantly as the business matures and spends relatively less on these items.
Measuring revenue makes sense for a growing SaaS valuation, but it is important to note that this valuation philosophy is entirely based on growth. If the SaaS business does not grow then the revenue is not there to support the forecast profit in the future, which is what the valuation is based on.
So, what does this all mean for your SaaS business? The test for SDE vs EBITDA vs Revenue is therefore:
- Is the business reliant on the owner?
- Are revenues growing less than 50%+ YoY?
- Does the business generate <$2,000,000 revenue per year?
An answer of “yes” to any or all the above means the SaaS business is one for a valuation using SDE. Investors will likely appraise the business based on this benchmark alone and apply a multiple to arrive at the final business valuation. If the answer is “no”, EBITDA or revenue might be more appropriate.
How do you decide the multiple?
The multiple is one of the most important pieces of the equation and is affected by dozens of factors related to the business. Those factors span a wide variety of financial, traffic and operational aspects, but ultimately it boils down to the sustainability, scalability, and transferability of the business.
Any operational or market factor that directly or indirectly impacts these core drivers will influence the multiple.
- How old is the business?
- How has gross & net income been trending for the last 1-3 years? The last few months?
- Can a new owner replicate the cost structure? Can they make any savings?
- Are there any anomalies in the financial history of the business? If so, are they explained?
- Can all the revenue streams be transferred to a new owner?
- How stable is the earning power e.g. are CPMs in this niche on the decline/hard to replace?
- Is the owner an influence on the earnings power (i.e. owner-specific earning relationships)?
- What percentage of traffic comes from search? (i.e. what percentage is potentially at risk from search engine algorithm changes)
- How secure are the search rankings? What is the mix of short and long tail?
- How has traffic between trending for the last year? The last few months?
- Has the site been affected by any Google algorithm changes or manual penalties?
- What is the industry trend (see Google Trends)?
- Where does the referral traffic come from? Is it sustainable?
- How much of the owner’s time is required to run the business?
- What are the owner’s responsibilities? Are there high technical requirements?
- What technical knowledge is required to run or manage the business?
- Are there employees/contractors in the business and how are they managed?
- How competitive is the niche?
- What are the barriers to entry?
- Is the niche growing?
- What are the recent trends and developments in the niche?
- What expansion options are available?
- Where does the business get customers from?
- How much do customers cost to acquire?
- If subscription, what is the customer lifetime value and churn rate?
- If one-time, how active is the customer base? Are they re-ordering?
- Is it possible to remarket to the existing customers? Is there a mailing list?
- Are there physical assets or specific regional responsibilities with the business?
- Are there any licensing requirements to run the business?
- Does it infringe in any trademarks?
- Does the business offer any unique advantages? (e.g. trademark)
This is a summary of the questions and factors involved in a full SaaS business valuation. Experts also look at DCF modeling, historic price and revenue regression analysis for comprehensive analysis.
How Much is Your SaaS Business Worth?
SaaS businesses typically fall within the 3x – 4.75x annual profit (SDE) range, and this can be determined by many SaaS metrics.
In the initial assessment it is useful to filter these variables into a few that have the most influence:
- Age of the business
- Owner involvement
- Growth trends
- Churn and other SaaS metrics
Evaluating the above metrics helps determine whether a SaaS business’ multiple falls towards the low or premium end of the valuation spectrum:
- Age of the business: A SaaS business with a longer track record demonstrates that it has proven sustainability and is also easier to predict in terms of future profit. Businesses that are 2 years old are the preferred entry point, and at 3+ years they start to receive more of a premium multiple. Younger businesses are still sellable, albeit to a slightly smaller investor audience that may have a higher risk tolerance.
- Owner involvement: Part of the appeal of running a SaaS business is the potentially passive and predictable nature of the income it brings. Businesses that require relatively little time and have a team in place are more attractive than those that require a lot of owner work. Outsourcing can help here. The other dimension to this is the technical involvement of the owner. If an investor must replace an owner that is performing a highly skilled role, this will either increase the replacement cost or put off non-technical investors, which reduces overall demand for the business.
- Trends: Few investors aspire to acquire a SaaS business that is declining, and correspondingly few owners want to sell a SaaS business that is growing rapidly. The key is to sell a business that is trending consistently and, ideally, modestly upward. Naturally, the faster the business is sustainably growing, the more the multiple will stretch toward the premium end.
- Churn: It is well documented that customer metrics are of vital importance for SaaS business owners and consequently they are of great interest to investors. Churn, lifetime value (LTV) and customer acquisition cost (CAC) are analyzed by investors when appraising the customer base and by virtue the quality of the business’ revenue.
While the general valuation drivers above are a key consideration, it’s important to note that every SaaS business is unique, and each has its own priorities in terms of metrics. As the valuation process goes deeper, more business model-specific factors come into play when determining the final multiple.
Which SaaS Metrics Matter Most?
Investors looking to buy a SaaS business are looking for points of strength and differentiation. To determine the points of strength and differentiation, investors will often look at a few key metrics.
Churn is a significant driver of valuation because it touches upon all the key factors that impact the perceived future cash flows of a SaaS business. The importance of this metric should not be underestimated when you consider the long-term impact on the business.
Provided there is a consistent flow of new customers at an acceptable cost of acquisition rate, low churn will allow recurring revenues to grow, improving the growth rate and reducing the risk of value loss over the long term. A high churn rate has all the inverse effects and can also say to investors that the product does not adequately fit the customer’s needs, sits in a market with limited demand or there are stronger competing products. This would imply that the product requires further development at their expense.
How Much Churn?
The importance of churn is widely accepted. However, it is less easy to find consensus on the acceptable rate of monthly revenue churn for SaaS businesses.
To begin with, most SaaS businesses focus on servicing the needs of small to mid-sized businesses. Small businesses have lower demands and less sophisticated needs, so this is an easier point of entry than enterprise-grade software.
The challenge though is that smaller customers tend to have higher churn rates. SMB customers tend to alternate SaaS products more regularly because switching costs are low and are more likely to go out of business.
Customer Acquisition Cost (CAC) and Customer Lifetime Value (LTV)
The Customer Acquisition Cost (CAC) is the total marketing and sales cost to acquire one additional customer. Obviously, the lower this number is the better, as that would mean you are spending less to acquire customers. However, there is no magic number when it comes to CAC because each SaaS business is going to be different. To make an apples-to-apples comparison we first need to incorporate an additional metric – Customer Lifetime Value (LTV).
LTV is the average amount of revenue that is earned from a customer throughout the time they are paying for the service. The higher the LTV is the more valuable each new customer is to the business. Just like CAC, there is no standard LTV number. Once again, the number will vary depending on the business model, market, competition, and a multitude of other factors.
To truly get the most use out of these two metrics we must compare them to each other. In doing so, we will get a ratio that will quickly tell if a business is making more revenue per customer than it is spending to acquire that customer. This allows us to measure the return on investment of marketing efforts and determine if the growth strategy is working.
The general rule of thumb is that an LTV/CAC ratio of 3 is ideal for most SaaS businesses. This will allow for enough cushion to account for a dip in the LTV or an increase in the CAC and still be able to generate a healthy gross profit margin.
MRR vs ARR
In small- and mid-market, self-funded SaaS businesses, the temptation is to sell reduced priced annual plans to increase top-line revenue and improve cash flow to reinvest into growth. While in many situations this is necessary, from a valuation perspective it will hold the business back. The same goes for selling lifetime plans – these are a big no-no when it comes to increasing the value of a SaaS business.
This is often the opposite of what an owner of a SaaS business will look to do, especially when looking for growth capital. Even if it slows growth, focusing on selling monthly plans is key to achieving higher valuations. MRR is valued around two times higher than equivalent revenue from lifetime plans, so this can often outweigh the benefits of the short-term cash flow boost.
The average SaaS business sold has 5:1 ratio of MRR to ARR – this is an ideal mix to aim for to maximize valuation. Generally, these products will have annual plans priced 10-20% less than monthly plans and years of ARR churn data. SaaS products with a higher ratio of annual plans would see a lower valuation as the revenues are less predictable.
Other Factors to Consider When Valuing a SaaS Business
Customer Acquisition Channels
Acknowledging the higher rate of churn that small- and mid-market, SME-facing, SaaS businesses experience, customer acquisition is understandably a focal point for evaluating the longevity of these businesses. If the business is losing 30-50% of its customers per year, the only option is to add a significant number of new customers each month to counteract the loss (at least in the short-to-medium term).
The customer acquisition channels of a SaaS business are thus of great importance to investors, who tend to evaluate these in terms of concentration, competition, and conversion.
Concentration. A premium SaaS business will acquire customers from a multitude of channels, be it organic search, affiliate, paid or otherwise. Having a diversity of channels not only reduces the dependency on one channel but also proves its monetization in multiple ways. SaaS businesses that have successful organic and paid channels benefit from this premium with investors.
Naturally, many small- and mid-market SaaS businesses build their customer acquisition from content marketing before exploring paid and affiliate channels. It can be a worthwhile experiment to trial the 3-6 months ahead of an exit to see whether they yield positive ROI. Not only will this improve the value of the business’ earnings (and thus the SDE for valuation) but it will demonstrate to investors that the business can be monetized in multiple channels.
Channel Competition. The defensiveness of each acquisition channel is of interest to investors when evaluating their strength. If the business has a strong backlink profile and ranks well for a high number of relevant keywords this is considered a strong, defendable platform for organic customer acquisition.
Conversely, if the business is engaged in price-wars in paid search with competitors, this is understandably considered a weaker acquisition channel. Search “project management software,” for example, to see ads for several different well-funded companies competing for the term. Small- and mid-market SaaS business trying to outbid in that niche will suffer a short-lived PPC lifecycle.
Conversion. The ultimate appraisal of customer acquisition channels are the associated conversion and cost attached to each. Here the conversion-to-trial ratio and conversion-to-paid ratio are carefully eyed by investors, as well as the associated CAC.
To summarize, a premium SaaS business is one that has multiple customer acquisition channels with high defensiveness and solid conversion metrics for each.
Eventually all software needs development to keep up with customer requirements or to grow the business further. A product’s development roadmap can be dictated by a number of factors, including customers, competition or even the owner’s ambition.
While every SaaS business is unique in its development requirements, when the business comes to market, it is generally best practice to have the product in a high point of its development life-cycle, or in other words, not requiring a major update any time soon. This gives the new owner some runway ahead of any major development and provides some comfort that the current management has not simply given up on the business and is passing over ownership at a time when the product needs care and attention.
The amount of owner involvement in the business and particularly the nature of the work can be a sensitive valuation factor for SaaS businesses. At first this might seem counter-intuitive to a SaaS entrepreneur. More technical input from the owner (i.e. development) suggests a sophisticated product, which implies unique IP and a high-quality product.
All the above could be true, but an investor still needs to either be able to do the same work themselves or pay for someone else (usually at a high cost). Factoring this into the SDE will ultimately lower the valuation.
One might be tempted to instead pursue investors that can readily resume the same responsibilities themselves (i.e. purely seasoned SaaS business owners) but this can reduce the pool of available investors significantly.
Competition in the niche is of great interest to investors when evaluating a SaaS business. Clearly the level of competition is important to understand for any business acquisition, but this is especially true in the SaaS space.
In SaaS it becomes of acute interest because of the generally higher number of VC-funded players in the industry and the high development costs associated with the business model. Small- and mid-market SaaS business in a highly competitive niche will tend to find itself under-funded and unable to compete with the development efforts and features of better-funded, VC-backed SaaS companies.
The SaaS businesses that achieve a premium are almost always products that are prepared for growth at scale.
What Can You Do to Increase the Value of Your SaaS Business Before a Sale?
An exit strategy for any business is crucial before a sale.
You can add hundreds of thousands of dollars of value to a business by taking the right steps before a sale.
Naturally not all the valuation factors are addressable (e.g. competition in the niche) but there are several strategic moves you can make to increase the value of your SaaS business before a sale.
1) Reduce Churn
With churn such an important aspect of SaaS valuation, it’s a key element to try to reduce ahead of coming to market.
2) Outsource Development and Support
There is both a ‘passivity premium’ and a non-technical premium that can be attached to SaaS businesses that have effectively and reliably outsourced development and customer support.
Outsourcing these two components can lead to a multiple premium of anywhere between 0.5x – 0.75x. It can also reduce the buyer’s assumed owner replacement cost which lifts the business’ earnings for multiplication and thus the valuation even higher. This double-win means that effective outsourcing is one of the greatest levers of exit value for SaaS business owners.
The focus here should be on effective and proven outsourcing. A haphazard attempt to move customer support to an unproven call center in foreign country will not be regarded favourably.
3) Secure Intellectual Property (IP)
It might seem obvious, but a surprising number of business owners fail to properly secure their intellectual property ahead of a sale, which can have detrimental effects on the transaction later.
Securing IP is important for SaaS businesses, particularly for transactions of >$500K where the cash cheque being written starts to become significant. Ideally this should have been pursued in the early stages of the business’ development but there is no harm in retroactively applying for a trademark ahead of a business sale. Trademarks tend to be easier, shorter, and less expensive to apply for than patents.
Securing IP doesn’t just stop at trademark filing. Any individual that was involved in writing code or developing the product should be asked to sign an IP assignment for their work. This is particularly relevant to contractors hired from freelancer marketplaces as well as any other third-party company used. This is a standard due diligence request for larger ($500K+) larger SaaS sales but is worth securing right from the outset on any sized business.
4) Document the Source Code
A well-documented, annotated, and tested source code is a distinguishing factor of premium-valued SaaS businesses. Particularly on the upper end ($500K+), well-documented code is almost a must-have for investors that are looking to scale the business into 7-figures and beyond. It can be a deal-killing issue and is one that is readily avoidable through adequate preparation ahead of coming to market.
5) Position the Product
The position of the product development cycle is important to investors and influential on the exit multiple. Business owners plotting a sale should think about planning their next major upgrade 3-6 months ahead of going to market.
This has several short and medium-term benefits. First, it brings some immediate additional earnings to the current owner, assuming a positive uptake and increase in trials for new customers. Second, it lifts the earnings figure (the SDE) which forms the basis of the sale valuation. Third, assuming a positive take up, it will create positive customer feedback and potentially PR as well. Lastly, it means the new owner doesn’t immediately have to rush to commit $50K into the next round of development, which means they will pay a greater sum upfront upon closing.
6) Avoid Discounting
Tempting as it can be for some business owners, launching an unprecedented sale of annual plans to book a large amount of revenue ahead of a sale is not a wise strategy. Sellers have been known to do this to inflate the valuation ahead of a sale and to generate additional cash. Unfortunately, all buyers see through this strategy and either discount the relevant months or steer clear of the sale entirely. Unserved portions of packages sold on annual plans are often rebated to a new owner, so this is a pointless exercise.
The key to a successful exit is to continue to run the business in a similar fashion in the months before and during the sale. If a sale is seasonal (e.g. Black Friday), that is an acceptable event to run a discount. If it’s outside of normal proceedings, its best to avoid discounting altogether.
Salability: How Attractive is Your SaaS Business?
Ahead of going to market, you’ll need to look at the salability of your SaaS business, or rather, how attractive it looks to buyers and how attractive it is to own. This is broader than just the fundamentals discussed thus far; it comes down in large part to the operational setup.
Here are some tips to help you improve operations efficiently and effectively:
You’ll need to have detailed financials for your business to prepare for a sale. Accounting applications, such as QuickBooks, can be a big help, but make sure your accounting is up to date – and keep it that way as you enter the sale process.
Details are key, and so is organization. Serious buyers are unlikely to sift through months of financial records and tax returns to determine whether the investment is worth it.
You should also be prepared to give prospective buyers any analytics you have for past and current ad campaigns, email data and website traffic.
2. Operating Procedures
Your business doesn’t operate itself, even if you have a relatively passive business model. Prospective buyers will need to know the responsibilities involved in your operation, so document all your daily, weekly, and monthly processes and procedures. This will make the transition faster and easier for both of you.
Moreover, buyers may be more inclined to pay a premium for businesses with well-documented operations, so this step could easily translate to a higher profit for you.
3. Customer Metrics
When it comes to SaaS, metrics are vital to convincing buyers of the strength of the business. Seasoned investors in the space will review MRR, churn, LTV, CAC, retention, and your cash burn rate closely.
The good news is you don’t need to calculate these yourself. The SaaS analytics industry has a number of great solutions for business owners including Baremetrics (for Stripe), ChartMogul (for Stripe, BrainTree, Recurly and PayPal) and FirstOfficer (for Stripe) to name a few. Make sure to integrate these with your merchant processor well in advance of a sale, to capture the relevant historical data before going to market.
The prospective buyer for your business is not necessarily looking for a job, so if you’re able to reliably outsource tasks to agencies, contractors, or virtual assistants, do it. Online businesses that are more passive in nature tend to sell at a higher price than those that involve more work on the owner’s part.
Remember the ‘power of passivity’: it’s a potentially huge value driver for the sale of your business. Owners who can successfully remove themselves from the day-to-day of their business often find that they benefit from a higher valuation once they’re ready to sell. Virtual assistants can be very useful in this regard.
5. Powder in the Keg
If you’ve done the legwork developing a new feature and creating a marketing strategy around it, it can be worthwhile holding off on releasing before a sale.
The addition of a brand-new product or revenues will need 3-6 months of history to move a valuation higher (this is not unique to SaaS businesses). A smarter strategy is often to use this as leverage to gain stronger offers off the existing valuation and get a higher cash consideration upfront. This can often offset the perceived lost profit from delaying the release of the new product or upgrade.